At a Glance
The new ASC 842 lease accounting standard aims to increase transparency between companies and investors by establishing clear guidelines for proper lease management and lease accounting. ASC 842 primarily affects lessees; however, the new standard can also impact how lessors create and classify leases, necessitating accounting changes down the road.
Learn what changes lessors face upon implementing ASC 842, the key exceptions, and how ASC 842 may impact lessor accounting.
What Is ASC 842?
ASC 842 is the new lease accounting standard requiring public and private companies to track and disclose all their leased assets and liabilities on balance sheets. The ASC 842 lease accounting standard went into effect for public companies in 2019 and on December 15, 2021, for private companies. Private businesses that use calendar year reporting should follow ASC 842 guidelines starting January 1, 2022.
Under the previous lease accounting standard, ASC 840, companies could classify certain leases as operating leases and write them off as an operational expenses. With operating leases excluded from calculations like return on assets, investors received an incomplete picture of the company’s performance.
ASC 842 requires companies to differentiate between operating leases and financing leases on their balance sheet so that investors can understand the entire financial situation of the business.
Many companies have found it complicated and challenging to achieve compliance with ASC 842. While many private companies have started to change over to the new standard, 33% report that they are still not fully prepared for the transition.
Reasons for this delay vary, but most companies report that talent shortages, retention issues, knowledge maintenance, and new technology contribute to the transition’s difficulty.
Key Changes to Leases for Lessors Under ASC 842
Overall, the changes implemented in ASC 842 affect lessees more significantly than lessors. However, the new standard requires lessors to adopt new terminology and may have longer-term effects on lessor accounting and how lessors choose to grant leases in the future.
ASC 842 also slightly refines the definition of a lease. Consequently, what was once a single lease agreement may need to transition to multiple contracts or may no longer qualify as a lease at all.
ASC 842 allows lessors to retain the same basic lessor accounting model and classify leases as sales-type, direct financing, or operating based on criteria similar to ASC 840. However, lessors may need to alter or update specific systems, processes, and controls involved in the lessor accounting process to achieve compliance with the new standard.
Additionally, under ASC 842, all lessees with a lease term over 12 months on their balance sheet must recognize operating leases along with all other leases. To avoid this, lessors may experience customers opting for shorter leases or asking to change the terms and conditions of their lease.
Lease Classification Changes to Sales-Type and Direct Financing Leases
While the old standard that categorizes leases as either operating or capital (sales-type or direct financing type) has not changed much under ASC 842, the new standard does change the qualifications for sales-type and direct financing type leases.
ASC 842 guidance requires lessors to classify a lease as a sales-type lease if:
- The lease will transfer ownership of an underlying asset to the lessee by the time the lease term ends.
- The lease gives a lessee the option to purchase an underlying asset (and the lessee is reasonably certain to exercise this option).
- The term of the lease is a significant portion of the total economic life of an underlying asset.
- The sum of all lease payments and the residual value guaranteed, if any, by the lessee is greater than or equal to substantially all the underlying asset’s fair value.
- A leased asset is so specialized that it will have no further use to the lessor at the end of the lease term.
ASC 842 lessor accounting requires lessors to classify a lease as a direct financing lease if the lease does not meet the criteria for a sales-type lease and meets both of these conditions:
- The sum of all lease payments, the residual value guaranteed by the lessee, and any other third-party payments are greater than or equal to substantially all of the fair value of the underlying asset.
- A lessor will likely collect lease payments and other necessary amounts to satisfy a residual value guarantee.
If the lease doesn’t meet the conditions of either a sales-type lease or a direct financing lease, then that lease is an operating lease.
Exceptions Lessors Should Know
Lessors should make themselves aware of certain exceptions and specialized revisions they must make under ASC 842.
Give additional consideration to a lease if any of the following exceptions are present:
- Under ASC 842, real estate leases no longer require unique treatment and now follow standard ASC 842 guidelines like any other lease.
- You may classify leases predominantly consisting of variable lease payments as sales-type or direct financing.
- Any modifications to leveraged leases, which are effectively grandfathered under ASC 840, must be accounted for as an entirely new lease.
- Unlike ASC 840, ASC 842 does not include the concept of executory costs; these are now generally expensed rather than capitalized.
- ASC 842 offers more guidance for getting lease modifications aligned with ASC 606 (revenue recognition standard).
How ASC 842 Affects Lessor Accounting
The transition to the new ASC 842 standard does not substantially affect lessor accounting. Unlike the lessee, the lessor will generally not have to make any changes to the accounting process for operating leases.
Sales-type leases recognize selling profits and losses at the lease’s commencement. Direct financing leases recognize selling losses at lease commencement and selling profits over the lease term.
Windes Can Help Your Company Achieve Compliance
It can be challenging for a company to maintain compliance with the new ASC 842 standard without help from an ASC 842 lease accounting professional.
Windes’ lease accounting experts can help you address any disparities that may prevent your company from achieving compliance with the new ASC 842 lease accounting rules.
Windes offers ASC 842 services and expertise in numerous areas, including lease classification, disclosure requirements, and lease component analysis to businesses in Long Beach, Los Angeles, Orange County, and throughout Southern California.
Connect with us today to learn more about how Windes can help your company achieve ASC 842 compliance.